How outsized budget deficits impact the Fed’s decisions

One of the biggest challenges confronting the Federal Reserve is to ensure that large federal budget imbalances do not place undue pressure on it to keep interest rates artificially low and thereby generate higher inflation. 

This issue is likely to surface in the Senate Banking Committee hearings on April 16 to confirm Kevin Warsh’s nomination as the next Fed chair. Warsh has called for a new Treasury-Fed accord to update the 1951 accord that separated monetary policy from debt management. His goal is to shrink the Fed’s holdings of U.S. government securities that ballooned during the 2008 financial crisis and the COVID-19 pandemic. 

One consequence of the debt buildup is that it is more difficult to separate fiscal policy from monetary policy because of “fiscal dominance.” This is a condition whereby high government debt and persistent large deficits force a central bank to prioritize financing the government’s budget over controlling inflation. 

The backdrop is that federal debt outstanding has been on an unsustainable trajectory since 2017, nearly doubling to $39 trillion this year.  Meanwhile, interest payments on federal debt have risen at an even faster pace since 2021.  

Looking ahead, the Congressional Budget Office projects that annual net interest payments will double from $1 trillion this year to $3.1 trillion by 2036, assuming Treasury yields are unchanged from current levels. The office also projects that, barring any changes in government programs, Social Security’s Old-Age and Survivors’ Insurance Trust Fund will be depleted by 2032. 

Amid this, President Trump has prodded the Fed to lower interest rates so the economy can grow its way out of its debt problems. With his Fed chair nomination, Trump is banking on Warsh sharing his vision that the U.S. economy can grow much faster without rekindling inflation. 

Prior to his appointment, Warsh wrote a Wall Street Journal op-ed in which he described inflation as resulting from excessive government spending and Fed decisions to print too much money. He contended that all the other explanations for recent and past inflationary pressures are merely excuses for poor Fed decision making. He also claimed that the Fed’s bloated balance sheet was designed to support the biggest firms in the financial crisis era, and that it can be reduced significantly. 

Warsh’s assessment raises two questions that the Senate Banking Committee should ask. First, what should the Fed do if the federal government fails to rein in the budget deficit? Second, could his goal of shrinking the Fed’s balance sheet significantly have adverse consequences? 

Regarding the first issue, I share Warsh’s concern that increased government spending during the COVID-19 pandemic contributed to inflation by boosting aggregate demand. The Federal Reserve should have taken this into account when it kept interest rates at zero in 2021 even as the economy rebounded from the pandemic. That said, the current federal budget imbalance of 6 percent of GDP is twice as large as Treasury Secretary Scott Bessent’s 3 percent target. 

The outsized deficit mainly reflects lost revenues in the budget bill enacted last year that resulted from an extension of personal tax cuts enacted in 2017 and added tax cuts that President Trump campaigned on. The Tax Foundation estimates they could result in a revenue shortfall of $5 trillion over the next 10 years.    

Meanwhile, President Trump’s 2027 budget proposal released last week calls for boosting total defense discretionary spending to $1.5 trillion, which would be the largest defense budget in U.S. history. Even if the proposed $500 billion increase in spending is not enacted fully, growth of federal debt would still be too rapid.  

Regarding the Fed’s balance sheet, Warsh has stated that, “We should be shrinking the central bank balance sheet, taking the Fed out of these markets unless and until there’s a crisis.” While Fed holdings of U.S. government securities are down from a peak of 35 percent of GDP, Warsh believes they are still too large at 21 percent of GDP.  

Warsh’s push to shrink the balance sheet, however, is likely to encounter resistance from Federal Open Market Committee members who halted quantitative tightening in December after bouts of stress in funding markets. The committee is cautious about large balance sheet reductions because they drain bank reserves and can destabilize the repo market as in September 2019, when the repo rate surged from 2 percent to 10 percent. Officials believe recent conditions could signal they were close to pulling too much money out of the financial system. 

Finally, if the Fed lowered short-term rates and pared back its holdings of Treasuries, the Treasury yield curve would likely steepen. If so, it could boost growth in the near term, albeit at the expense of long-term growth. 

The bottom line is that large fiscal imbalances leave the Fed in a box that limits its ability to lower rates. 

Nicholas Sargen, Ph.D., is an economic consultant and is affiliated with the Darden School of Business. The second edition of his book, “Global Shocks,” is forthcoming.

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